Credit scores are those three digit numbers which can be an investor’s best friend just as easily as it can become one’s worst nightmare.
What is a credit score?
Your credit score is used by lenders to determine how likely they are to receive payment in full and on time when assessing a potential borrower. The higher your credit score, the lower your credit risk whereas a lower credit score indicates a higher credit risk.
How is your credit score calculated?
Credit scores are calculated based on five categories. Understanding these categories will help you improve your credit score so you know where to focus your efforts. You’ll also have a better understanding of whether different actions will likely have a positive or negative impact.
- Length of Credit History
- Payment History
- Credit Utilization Ratio
- New Credit
- Overall Financial Capacity
Next we’ll discuss how you improve your credit score by focusing your attention to each of these categories.
How to improve your credit score
There are five main factors that are generally considered when calculating your credit score. By focusing on each of these categories you can focus your efforts to improve your credit score.
- Length of Credit History
The two major factors here are your average account age and your credit mix. First off, the older your credit history the better. Second, your credit mix considers all the different types of credit you’ve been approved for, as well as the average account age. To help boost your credit score from this factor, try to avoid completely closing any accounts as it may lower your overall average account age. Of course, this is most relevant when the account at question is older than your average account age.
- Payment History
Your payment history refers to how often you make payments on time and in full. The more frequently you do both of these things the better it is for your credit score.
- Credit Utilization Ratio
This refers to your credit utilization ratio which represents the amount of your credit limit that is currently in use. A good rule of thumb is to ensure your credit utilization is never more than 30% of your limit. If you are currently above this suggestion, consider increasing your credit limit or opening a new account. This comes with the caveat that you must not spend the additional credit you receive in order to truly benefit from this.
- New Credit
Applying for lots of new credit all at once – including a variety of types (credit cards, mortgages, auto loans, etc.) – is often seen as risky behavior. Keep in mind, applications in each of these loan categories will trigger a hard credit inquiry to your credit history. Always be aware of how new credit may affect your credit score.
- Overall Financial Capacity
This refers to the total debt you already have in relation to your other financial obligations and income streams. If you’re in a situation to easily service all of your existing and new debts, then you shouldn’t need to worry about this much. However, if you already have lots of accumulating debt, then you should be especially wary of this.
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